UK regulators are concerned that a new form of bonds, widely expected to be launched by banks around the world as a replacement for discredited hybrid securities, risk endangering the stability of financial markets if they are overused.
Senior regulatory figures told the Financial Times that, if misused, the so-called contingent convertible bonds, the first of which were launched by Lloyds Banking Group this week, could prove “unsettling” and would add an “extra dimension of risk” to capital markets.
The concerns emerged after Lloyds launched a £21bn capital raising that included plans to issue £7.5bn of enhanced capital notes, also known as contingent convertibles, or CoCo bonds, which convert from debt into equity if the bank’s core capital ratios fall to dangerous levels. Analysts and investors predicted other banks would widely copy the model.
The Financial Services Authority gave the go-ahead to the Lloyds deal, and regulators at both the FSA and the Bank of England believe that CoCo-style instruments would, in principle, become a desirable part of banks’ capital structures in future. This is mainly because they could act as a replacement for hybrid debt, much criticised during the financial crisis as a weak capital instrument.
Lord Turner, chairman of the FSA, this week urged banks “to create a role for contingent capital”.
Hybrids disappointed both investors and regulators during the crisis as some issuers deferred coupons and others refused to use the funds as if they were loss-absorbing equity.
CoCo bonds explained
FT interactive graphic: Why contingent convertible capital was created and how it works
CoCos, by contrast, commit the issuing bank to convert the bonds into equity if a certain capital strength threshold is breached – in Lloyds’ case, if its core tier one capital ratio falls below 5 per cent from the 8.6 per cent it expects to report following its recapitalisation.
But investors and regulators alike have voiced concerns that these bonds, by design, convert into equity at a time when the bank’s share price is likely to already be under pressure. “If you had too much contingent capital, the very act of converting it could be unsettling,” said one European regulator. One investor called the instruments “equity time bombs”.
Regulators believe that if a limit is set on the volume of such funding that a bank can raise as a proportion of overall capital or of the bank’s asset base, the instrument will work effectively.
Some critics have made the comparison with so-called “death spiral convertible” bonds, used in Japan in the early 1990s. Ultimately, many experts concluded the instruments did more harm than good because the expectation of a swathe of debt converting into equity exacerbated share price declines and investor panic.
But those backing the Lloyds CoCos say these bonds are structured differently and have the reverse effect by increasing the bank’s strength at a critical time.
Although Lloyds’ issue was broadly welcomed by investors when launched on Tuesday, critics say it is unlikely to be representative of broader demand for such an instrument.
Lloyds’ coupon-paying CoCos will replace existing debt, on which coupon payments have been barred by European state-aid authorities in retribution for the bank’s bail-out by the UK government. Other banks, issuing new CoCos, might find a less enthusiastic reception from investors.
